Microsoft made headlines recently when the company surprised analysts and investors by announcing the most generous one-time corporate dividend in history. By paying out $3 per common share, or $32 billion to its shareholders, the company passed along more than half of the $60 billion in cash it had accumulated.
Many of the leading corporations in America appear to be in the same position: They are taking in more cash than they are spending. As the New York Times recently reported, American companies have more cash on hand than at any time since World War II.
Without including the financial sector, American companies have $550 billion in cash on hand, compared to less than $500 billion at year-end 2003 and $260 billion at the peak of the dot-com boom.
According to the Fed, corporate cash flows are running at about 20 percent of sales ? which is well above the long-term average of 15 percent of sales. Moreover, they are even higher than the record cash flows of 17 percent of sales, which companies experienced when the economy was booming in the late 1990s.
At the same time, companies are spending less than they usually do, even as the economy has recovered. Firms are not rebuilding their inventories; instead, they’re producing just enough products to satisfy demand. On average, companies are keeping just 1.3 months of inventory on hand, which represents a record low. So the mountain of cash keeps growing.
Executives have also shown little interest in capital spending. It’s true that, in the past year, real spending on capital equipment like computers and software has grown rapidly. Yet capital spending is only 90 percent of depreciation. In the 1980s and 1990s, it hovered at 130 to 140 percent of depreciation.
Capital spending isn’t keeping pace with cash flows, either. Currently, capital spending equals about 8 to 9 percent of sales. Milton Ezrati, the Senior Economic Strategist for Lord, Abbett & Co., notes that’s well above from the lows of 2002 and early 2003, but still far below cash flow margins, and also below historic norms of closer to 10 to 12 percent of sales.
Therefore, Ezrati explains, “Even accounting for options, dividend payouts, share repurchases, and cash acquisitions of other firms, the flow of excess corporate cash remains impressive. For the largest 1,500 U.S. corporations, for example, money allocated for new options amounts to about 0.6 percent of sales, for dividend payouts about 2.2 percent of sales, for share buybacks about 0.6 percent of sales, and for cash acquisitions about 1.8 percent of sales. Adding these outlays to spending on inventories, capital goods and structures still leaves a surplus cash flow approaching 6 percent of sales. That is a remarkably high figure. In past recoveries, business by the second year of growth had already turned to borrowing to supplement cash flow in support of its spending. But this time, surplus has already built to a corporate cash hoard of over half a trillion dollars. It approaches 10 percent of all assets. During the 1980s, and 1990s, that percentage seldom exceeded 6 percent.”
What are the implications of this unprecedented accumulation of cash?
If companies haven’t been spending because of a lack of opportunities, the long-term outlook for U.S. corporations is negative. Businesses must invest in new technologies, processes, and technologies to stay productive and profitable.
Ezrati doesn’t believe this is the case. Advances in technology, and the growth of the markets in China and India, have given American companies even more opportunities to pursue.
Therefore, it seems likely that corporate spending is down because senior managers are all too aware that the aggressive moves and reckless accounting of the past decade have come back to haunt their peers. There’s also a sense of uncertainty about new investments, due to the wars in Iraq and Afghanistan, and the continuing threat of further terrorist attacks on the home front.
This cautious approach is a good sign for the future of individual companies and for the economy as a whole. Ezrati notes, “A little less exuberance on capital spending might slow the pace of the economy’s upturn, but it also might enable the expansion to persist for longer and with less overheating than in the past. Further, a more cautious spending program might avoid the mistakes so typical of the hurried pattern of the past and consequently might further enhance future efficiencies and hence margins.”
As Ezrati sees it, the future holds four alternatives for corporate America:
- It can pay down debt. - It can step up capital spending. - It can increase mergers and acquisitions. - It can return the funds to shareholders through options, stock repurchases and greater dividend payouts.
Based on these scenarios, we expect the following five developments to unfold:
First, America’s corporations are not likely to pay down their debt. As Ezrati points out, most big companies secured their debt under favorable terms, so they will be in no hurry to get rid of it.
Second, don’t be surprised to see businesses increase their capital spending. With their surplus of cash, investments in new computer systems and software will continue to grow at double-digit rates as they have in the past 12 months. This spending will allow companies to operate more efficiently, drive up profit margins, and help drive up stock prices. Ezrati asserts, “Some might argue, convincingly too, that today’s huge cash flow and profit margins are a direct result of the efficiencies won by the capital spending surge of the mid-to-late 1990s. Channeling today’s excess cash flow into capital spending would promise to sustain these favorable margin patterns into the more distant future.”
Third, corporations with a surplus of cash will find it hard to resist making acquisitions. It just seems to be human nature for CEOs to want to buy other firms, despite the fact that nearly 75 percent of acquisitions underperform expectations due to employee defections and poor integration of the new business into the old one. Therefore, investors and employees should hope that management of their companies will be highly selective in seeking just the right firm to acquire, at just the right price.
Fourth, many cash-glutted companies will follow Microsoft’s example and issue dividends to their shareholders. This will be good for the stock market and for the economy in the short term. It is also likely to be good for the company’s stock performance. The New York Times reported in July 2004 that, on average, stocks in the S&P 500 that pay dividends have gained nearly 5 percent for the year, compared to a loss of 3.5 percent for stocks that do not pay dividends.
Fifth, two once-popular alternatives that companies will avoid are options and stock buybacks. As Ezrati points out, the corporate scandals of recent years will discourage boards of directors from granting options to executives. And while some businesses will buy back their stock, the new tax laws have taken away the benefit of receiving capital gains instead of dividends.
References List : 1. The New York Times, July 22, 2004, "Companies With Cash Hoards Don’t Necessarily Pay It Out," By Jonathan Fuerbringer and Danny Hakim. ⓒ Copyright 2004 by The New York Times Company. All rights reserved.2. Economic Insights, July 30, 2004, "Cash Flow and Capital Spending," by Milton Ezrati. ⓒ Copyright 2004 by Lord Abbett Distributor LLC. All rights reserved. o To access Milton Ezrati’s commentary "Cash Flow and Capital Spending," visit the Lord Abbett website at: www.lordabbett.com/usa/insights/article.jsp?OID=131423. ibid. 4. The New York Times, July 22, 2004, "Companies With Cash Hoards Don’t Necessarily Pay It Out," By Jonathan Fuerbringer and Danny Hakim. ⓒ Copyright 2004 by The New York Times Company. All rights reserved.
